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Fundamentals of pension accounting and funding

Fundamentals of Current pension funding and accounting For Private Sector pension Plans An analysis by the pension Committee of the American Academy of Actuaries July 2004 The American Academy of Actuaries is the public policy organization for actuaries practicing in all specialties within the United States. A major purpose of the Academy is to act as the public information organization for the profession. The Academy is non-partisan and assists the public policy process through the presentation of clear and objective actuarial analysis . The Academy regularly prepares testimony for Congress, provides information to federal elected officials, comments on proposed federal regulations, and works closely with state officials on issues related to insurance. The Academy also develops and upholds actuarial standards of conduct, qualification and practice, and the Code of Professional Conduct for all actuaries practicing in the United States.

Fundamentals of Current Pension Funding and Accounting For Private Sector Pension Plans An Analysis by the Pension Committee of the American Academy of Actuaries

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Transcription of Fundamentals of pension accounting and funding

1 Fundamentals of Current pension funding and accounting For Private Sector pension Plans An analysis by the pension Committee of the American Academy of Actuaries July 2004 The American Academy of Actuaries is the public policy organization for actuaries practicing in all specialties within the United States. A major purpose of the Academy is to act as the public information organization for the profession. The Academy is non-partisan and assists the public policy process through the presentation of clear and objective actuarial analysis . The Academy regularly prepares testimony for Congress, provides information to federal elected officials, comments on proposed federal regulations, and works closely with state officials on issues related to insurance. The Academy also develops and upholds actuarial standards of conduct, qualification and practice, and the Code of Professional Conduct for all actuaries practicing in the United States.

2 2 Fundamentals OF CURRENT pension funding AND accounting FOR PRIVATE SECTOR pension PLANS In general, pension plan sponsors are concerned with two primary financial issues: pension funding the cash contributions that are made to the pension plan. pension funding is governed by laws described in the Internal Revenue Code (IRC), which determine the annual minimum required contribution and the annual maximum tax-deductible contribution. pension accounting the annual pension expense calculation and disclosure of a pension plan s assets and liabilities in a company s financial statement. The Financial accounting Standards Board (FASB) governs pension accounting under generally accepted accounting principles (GAAP) in the Amounts calculated under pension funding rules are completely different than those calculated for pension accounting , and one must be careful not to mix the two topics. pension PLAN COST: THE BASICS The cash contribution and pension expense calculations are both often referred to as the cost of a pension plan one as a cash outlay and the other as a reduction (or increase) in company earnings.

3 Both are calculated using similar principles, although the rules for calculation are very different. pension plan formulas are generally designed to tie the participants benefits at retirement to their compensation and/or service with the employer. Each employer chooses how to reflect compensation and service based on their individual business needs and the needs of their workforce. Pensions are a form of deferred compensation. Participants trade compensation today for future pensions tomorrow. Both the pension funding rules and pension accounting rules require that the cost of that deferred compensation be recognized as it is earned. An actuary takes the plan s pension formula and determines how to reflect the cost of the plan over each participant s working lifetime. There are three basic principles used: Active participants earn new benefits each year. Actuaries call that the normal cost. The normal cost is always reflected in the cash and accounting cost of the plan.

4 Actuaries must consider the difference between the actuarial liability, which is the value of benefits already earned, and the assets. An unfunded liability, when the actuarial liability exceeds the assets, will increase cost. An asset surplus, when the actuarial liability is less than the assets, will decrease cost. Actuaries set assumptions to measure the normal cost and the actuarial liability. Measuring assets is relatively easy, because we have markets to set a value to the equity and bond investments held in the pension trust. However, there is no market of freely traded pension liabilities. Actuaries and plan sponsors are given very specific, and different, guidance by the IRS and the FASB about how those assumptions are chosen, who chooses them, and what conditions they must reflect. 3 The rest of this paper will deliver more detail on: How assumptions are usually selected; How the normal cost and actuarial liability are typically calculated; How funding rules use the normal cost and actuarial liability to determine cash contributions; and How accounting rules use the normal cost and actuarial liability (called service cost and benefit obligation in Statement of Financial accounting Standard (SFAS) No.)

5 87) to determine pension expense. ACTUARIAL ASSUMPTIONS Why do actuaries set assumptions? pension benefits are paid far out into the future, but how and when they ll be paid is uncertain. Today s 70-year old retirees are promised payments for the rest of their (and perhaps their spouse s) lifetime. How long will they live? How long might their spouse survive them? Today s 30 year-old active participants will earn additional benefits, terminate employment, and receive payments for the rest of their lifetimes. How long will 30-year olds work for their employer? How might their pay increase? When will they start to receive their retirement benefits? How long will they live after retirement? Both pension funding and accounting require assumptions to be made about the future. These assumptions are called actuarial assumptions and they, along with current plan participant data and the benefit formula described in the pension plan, are used to project future benefits.

6 For pension funding , the law gives the plan s actuary responsibility for the selection of actuarial assumptions. For pension accounting , the plan sponsor selects the actuarial assumptions, with guidance from the actuary. Actuarial assumptions for pension accounting are also generally reviewed by and approved by the company s external auditors in their general auditing of a company s financial statements. There are two primary types of assumptions selected: Economic assumptions dealing with current interest rates, salary increases, inflation and investment markets. How will market forces affect the cost of the plan? Demographic assumptions about the participant group make-up and expected behavior and life expectancy. How will participant behavior affect the cost of the plan? Several key actuarial assumptions are described in more detail below. Economic Assumptions Interest Rate For pension funding , this assumption is used to discount future benefits to determine plan liabilities and it should be a reasonable expectation of the future rate of return on the pension plan s assets.

7 It is often called the valuation interest rate. Different plans 4will have different valuation interest rates, reflecting different investment strategies and varying opinions of future rates of return. It is typically selected as a long-term reflection of plan assets and liabilities. For pension accounting , this is called the discount rate and must reflect either the market rates currently applicable to settling the benefit obligation or the rates of return on high quality fixed income securities at the measurement date. The measurement date is a date selected by the company that is generally the last day of the company s fiscal year but may be up to three months earlier. For example, if a company s measurement date is the end of a calendar year fiscal year, each 12/31 the company selects a discount rate based on applicable external interest rates as of that date. The selected discount rate is used to disclose the benefit obligations as of that 12/31 and then used to determine the pension expense for the next fiscal year.

8 The discount rate does not change until the next 12/31 unless a significant event occurs requiring a remeasurement of the benefit obligations. Expected Long-term Rate of Return on Assets This assumption is only used for pension accounting . It is used to determine the expected return on assets during the year. This assumption reflects the average rate of earnings expected on current and future investments to pay benefits. It is a long-term assumption that is reviewed regularly but generally changes when the long-term view of the market changes or with shifts in the plan s investment policy. Salary Scale This assumption is used to project an individual s future compensation in pension plans that provide benefits based on compensation. The salary scale assumption reflects expected inflation, productivity, seniority, promotion and other factors that affect wages. Inflation For pension accounting , this is used to project items, such as IRC limitations on benefits and compensation, which increase with the Consumer Price Index (CPI).

9 1 Inflation is also used as a basis for determining other economic assumptions because inflation is a fundamental component of each of the economic assumptions. Demographic Assumptions: Actuaries use rates (probabilities) to model the uncertainty of participant behavior. For example, because some participants will retire early, some will retire at 65, and some will work to age 70, an actuary might assume that each individual has some probability of retiring early, at 65, and working to 70. Sometimes assumptions will be the same for many plans ( , mortality rates) and sometimes assumptions are very specific to a given employer s workforce ( , rates of terminating employment before retirement). Some typical demographic assumptions are: Withdrawal or Termination Assumptions how long will participants continue to work for this employer? Mortality Assumptions how long will people live? Retirement Assumptions when will participants retire and begin receiving benefits?

10 1 IRC funding rules prohibit the actuary from projecting increases in IRC limitations on compensation and benefits when calculating the minimum required or maximum tax-deductible contributions to the plan. 5 Disability Assumptions will participants become disabled and no longer be able to work? BASIC pension LIABILITY PRINCIPLES A pension plan s liabilities can be calculated in different ways, but the same principles always apply. The actuary calculates the expected future pension payments for each participant in the plan using the company s participant data and plan provisions. These future benefit payments consider the individual s compensation and service history, and when that individual might be expected to die, quit, become disabled or retire. Each future payment is discounted from the date of payment to today using the actuarial assumptions. Actuaries call this discounted amount the present value of future benefits (PVFB) and it represents the present value of all benefits expected to be paid from the plan to current plan participants.


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